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Daxsly – Do you still want to invest in LIC

“We’re slowly learning that fact. And we’re very, very pissed off.”
—Lines from the movie Fight Club

The government’s piggybank is in trouble. Well, not major trouble. But, yes, some trouble.

Global credit rating agency Moody’s downgraded the Life Insurance Corporation (LIC) of India from a Baa2 rating to Baa3 rating. This is the lowest investment grade rating given by Moody’s. The top 10 ratings given by Moody’s fall in the investment grade category.

Moody’s downgraded LIC on Monday due to three reasons: a) for picking up stake in the divestment of stocks like ONGC, when no one else was willing, to help the government reduce its fiscal deficit; b) for picking up stakes in a lot of public sector banks; c) for having excessive exposure to bonds issued by the government of India to finance its fiscal deficit.

While the downgrade will have no impact on the way India’s largest insurer operates within India, it does raise a few basic issues which need to be discussed threadbare.

Hoping for the South Block office. PTI

From Africa with Love: The wives of certain African dictators before going on a shopping trip to Europe used to visit the central bank of their country in order to stuff their wallets with dollars. The African dictators and their extended families used the money lying with the central banks of their countries as their personal piggybank. Whenever they required money they used to simply dip into the reserves at the central bank.

While the government of India has not fallen to a similar level there is no doubt that it treats LIC like a piggybank, rushing to it whenever it needs the money.

So why does the government use LIC as its piggybank? The answer is very simple. It spends more than what it earns. The difference between what the government earns and what it spends is referred to as the fiscal deficit.

In the year 2007-2008 (i.e. between 1 April 2007 and 31 March 2008) the fiscal deficit of the government of India stood at Rs 1,26,912 crore. For the year 2011-2012 (i.e. between 1 April 2011 and 31 March 2012) the fiscal deficit is expected to be Rs 5,21,980 crore.

Hence the fiscal deficit has increased by a whopping 312 percent between 2007 and 2012. During the same period the income earned by the government has gone up by only 36 percent to Rs 7,96,740 crore. The expenses of the government have risen more than eight-and-a-half times faster than its revenues.

What is interesting is that the fiscal deficit numbers would have been much higher had the government not got LIC to buy shares of public sector companies it was selling to bring down the fiscal deficit.

Estimates made by the Business Standard Research Bureau in early March showed that LIC had invested around Rs 12,400 crore out of the total Rs 45,000 crore that the government had collected through the divestment of shares in seven public sector units since 2009. The value of these shares in March was around Rs 9,379 crore. Since early March the BSE Sensex has fallen 7.4 percent, which means that the LIC investment would have lost further value.

Over and above this the government also forced LIC to pick up 90 percent of the 5 percent follow-on offer from ONGC in early March this year. This after the stock market did not show any interest in buying the shares of the oil major. The money raised through this divestment of shares went towards lowering the fiscal deficit of the government of India.

News reports also suggest that LIC was buying shares of ONGC in the months before the public issue of the insurance major hit the stock market, in an effort to bid up its price. Between December and March before the public offer, the government first got LIC to buy shares of ONGC and bid up the price of the stock from around Rs 260 in late December to Rs 293 by the end of February. After LIC had bid up the price of ONGC, the government then asked it to buy 90 percent of the shares on sale in the follow on public offer.

This is a unique investment philosophy where an institutional investor managing money for the small retail investor first bid up the price of the stock by buying small chunks of it, and then bought a large chunk at a higher price. Stock market gurus keep repeating the investment philosophy of “buy-low-sell high” to make money in the stock market. The government likes LIC to follow precisely the opposite investment philosophy of “buying high”.

Estimates made by Business Standard suggest that LIC in total bought ONGC shares worth Rs 15,000 crore. The stock is since down more than 10 percent.

The bank bang: LIC again came to the rescue of a cash-starved government during the first three months of this year, when it was forced to buy shares of several government-owned banks which needed more capital. It is now sitting on losses from these investments.

Take the case of Vijaya Bank. It issued shares to LIC at a price of Rs 64.27 per share. Since then the price of the stock has fallen nearly 19 percent.

The same is with Dena Bank. The stock price is down by almost 10 percent since allocation of shares to LIC. The share price of Indian Overseas Bank is down by almost 19.7 percent since it sold shares to LIC to boost its equity capital. While the broader stock market has also fallen during the period it hasn’t fallen as much as the stock prices of these shares have.

There are more than a few issues that crop up here. This special allotment of shares to LIC to raise capital has pushed up the ownership of LIC in many banks beyond the 10 percent mandated by the Insurance Regulatory and Development Authority of India, the insurance regulator. As any investment professional will tell you that having excessive exposure to one particular company or sector isn’t a good strategy, especially when managing money for the retail investor, which is what LIC primarily does. What is interesting is that the government is breaking its own laws and thus not setting a great precedent for the private sector.

If LIC hadn’t picked up the shares of these banks, the fiscal deficit of the government would have gone up further.

The third issue here is why should the government run so many banks? The government of India runs 26 banks (20 public sector banks plus the State Bank of India and its five subsidiaries).

While banking is a sensitive sector and some government presence is required, that doesn’t mean that the government has to run 26 banks. It is time to privatise some of these banks.

Gentlemen prefer bonds: As of 31 December 2011, the ratio of government securities to adjusted shareholders’ equity in LIC was 764 percent. This is understandable given that the subsidy-heavy budget of the Congress-led UPA government has seen its fiscal deficit balloon by 312 percent over the last five years. Again, basic investment philosophy tells us that having a large exposure to one investment isn’t really a great idea, even if it’s a government.

The Rahul factor: But the most basic issue here is the fact that the government is using the small savings of the average Indian who buys LIC policies to make loss-making investments. This is simply not done.

LIC has turned into the behemoth it has become over the years by offering high commissions to its agents over the years. It sells very little of “term insurance”, the real insurance. What it basically sells are investment policies with very high expenses which are used to pay high commissions to it’s the agents. The high commissions in turn ensure that these agents continue to hard-sell LIC’s extremely high-cost investment policies to normal gullible Indians.

The premium keeps coming in and the government keeps using LIC as a piggybank.

The high front-loading of commissions is allowed by The Insurance Act, 1938. The commission for the first year can be a maximum of 40 percent of the premium. In years two and three, the caps are 7.5 per cent, and 5 per cent thereafter. These are the maximum caps and serve as a ceiling rather than a floor.

The Committee on Investor Protection and Awareness led by D Swarup, the then Chairman of the Pension Fund Regulatory and Development Authority, had proposed in September 2009 to do away with commissions across financial products. “All retail financial products should go no-load by April 2011,” the committee had proposed in its reports.

The National Pension Scheme (NPS) was already on a no-commission structure. And so were mutual funds since 1 August 2009. But LIC and the other insurance companies were allowed to pay high commissions to their agents. “Because there are almost three million small agents who will have to adjust to a new way of earning money, it is suggested that immediately the upfront commissions embedded in the premium paid be cut to no more than 15 percent of the premium. This should fall to 7 percent in 2010 and become nil by April 2011,” the committee had further proposed.

Not surprisingly the government quietly buried this groundbreaking report.

While insurance commissions have come down on unit-linked insurance plans, the traditional insurance policies in which LIC remains a market leader continue to pay high commissions to their agents. These traditional insurance policies typically invest in debt (read government bonds which are issued to finance the fiscal deficit).

This is primarily because the Congress-led UPA government needs the premium collected by LIC to run LIC like a piggybank. The piggybank money can and is being used to run subsidies in the hope that the beneficiaries vote for Rahul Gandhi in 2014.

Is the objective of LIC to generate returns and ensure the safety of the hard-earned money of crores of it’s investors? Or is it to let the UPA government run it like a piggybank in the hope that Rahul baba becomes the Prime Minister?